Frequent Trading + Optimistic Analyst Recommendations = Significant Misvaluations!
Stock Duration, Analysts Recommendations, and Misvaluation
- Cremers, Pareek and Sautner
- A version of the paper can be found here.
- A blog on an older version of paper can be found here.
- Want a summary of academic papers with alpha? Check out our Academic Research Recap Category.
This paper empirically studies how the interaction between short-term investors and analyst recommendations is related to a speculative component in stock prices. Using a new measure of the holding duration of institutional investors (called Stock Duration), we document that frequently traded stocks with optimistic (pessimistic) analyst recommendations have large negative (positive) future alphas that follow large positive (negative) past outperformance. Using Russell 2000 index reconstitutions to capture exogenous changes in institutional ownership, Stock Duration and analyst coverage, we conclude that strong analyst recommendations serve as a coordination mechanism among short-term, likely speculative, traders, causing significant misvaluations and subsequent price reversals.
Naïve investors are known as uninformed, emotional, and often overly optimistic. That’s why the market needs professional, well-informed analysts who can help disseminate information and mitigate such speculator optimism. Sounds good. But is it possible this is just the professionals are bias as well?
Academic literature shows that analysts are biased and thus might exacerbate, rather than mitigate investor biases. If analysts themselves are affected by past price increases and their own overconfidence and make overly optimistic forecasts, speculative investors may in turn overreact to these forecasts, leading to additional buying, and sustained price momentum.
So, what role do analyst recommendations play?
This paper empirically tests whether analyst recommendations mitigate or aggravate the price impact of speculative trading. The paper finds support for the latter interpretation. When frequently traded stocks receive optimistic analyst recommendations, they tend to have large negative future alphas following large positive past outperformance! Such price reversals only occur for stocks with two characteristics:
- are frequent traded
- have extreme analyst recommendations
The Two Main Components:
- A Proxy for Short-term trading/frequent trading — Stock duration: calculated as the weighted-average length of time that institutional investors have held a stock in their portfolio. Put simply, it measures “how long a $1 investment in a stock has on average been in an institution’s portfolio at a particular point in time.” If stocks have decreased institutional holding durations, they are owned by new, possibly speculative investors.
- Analyst recommendation: based on top and bottom quintile of the consensus or mean analyst recommendation. “A recommendation of 1 corresponds to “strong buy” and a recommendation of 5 corresponds to a “sell” recommendation.”
- In the first step, the paper sorts portfolios based only on Stock Duration. Table 2, Panel A shows that there is a positive relation between Stock Duration and future stock returns. Thus stocks with lower Stock Duration (decreasing institutional ownership), which are held by more short-term investors, are more likely to be misvalued.
- In the second step, the paper considers whether analyst recommendations mitigate or aggravate any price impact of speculative trading by short-term investors. In particular, the paper double sorts stocks on both Stock Duration and Mean Analyast Recommendation, and calculate subsequent holding returns for the next 12 months.
- Results show that the value-weighted portfolio of stocks with short stock duration and the most optimistic analyst recommendations has an annualized 5-factor alpha of -7.68% (-0.64%*12). On the contrary, the portfolio with short stock duration and the most pessimistic analyst recommendations has a 5-factor alpha of 6.48% per year (0.54%*12).
- So a long-short portfolio that buy stocks in the latter and sell stocks in the former has an annualized 5-factor alpha of about 14.2%! Figure 2B shows the cumulative returns of this short duration long-short portfolio.
- Stocks with extreme analyst recommendations exhibit significant price reversals only if held by short-term investors (more likely to overreact). The figure below shows that short Stock Duration stocks with extreme recommendations encounter price reversal over the subsequent 2 years.
- There is no price reversal of the past abnormal performance for the stocks with long Stock Duration.
So what frictions prevent arbitrageurs from trading away these price reversals? The paper points out that there are “Limit of Arbitrage“. The paper uses idiosyncratic volatility, the short-interest ratio, and ownership by Dimensional Fund Advisers (DFA) to measure shorting costs. The paper finds that when shorting costs are high, the short Stock Duration stocks returns encounter larger negative returns.
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Definitions of common statistics used in our analysis are available here (towards the bottom)